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Table of Contents Trading Spreads and Seasonals Chapter 1 What Is a “Spread?” If you already know what a spread is, you may be tempted to skip this initial chapter. However, I advise against it. Besides being presented for those who know, it is presented here for those who are not sure, and also for those who know that they know that they don’t know. I have been amazed at the number of traders who show up at my seminars who do not know what a spread is. Additionally, they do not know its numerous purposes or its many uses. A Spread is... For purposes of this book, a spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. You can turn that around and state that a spread is the purchase of one or more futures contracts and the sale of one or more offsetting futures contracts. A spread is also created when a trader owns (is long) the physical vehicle and offsets by selling (going short) futures. However, this course will not cover the long physicals, short futures types of spreads. Furthermore, for purposes of this course, a spread is defined as the purchase and sale of one or more offsetting futures contracts normally recognized as a spread by the futures exchanges. This explicitly excludes those exotic spreads that are put forth by some vendors but are nothing more than computer generated coincidences which will not be treated as spreads by the exchanges. Such exotic spreads as long Trading Spreads and Seasonals Bond futures and short Bean Oil futures may show up as reliable computer generated spreads, but they are not recognized as such by the exchanges, and are in the same category with believing the annual performance of the US stock market is somehow related to the outcome of a sporting event. Either way, for tactical reasons in carrying out a particular strategy, you want to end up with simultaneous long futures and short futures positions or, if you prefer, simultaneously short futures and long futures positions. The primary ways in which this can be accomplished are: 1. Via an intermarket spread. 2. Via an intramarket spread. 3. Via an inter-exchange spread. Intermarket Spreads An intermarket spread can be accomplished by going long futures in one market and short futures of the same month in another market. For example: Short May Wheat and Long May Soybeans. Intermarket spreads can become calendar spreads by using long and short futures in different markets and in different months. These spreads are specialized and uncommon, but it may be profitable for you know they are available. Intramarket Spreads Officially, intramarket spreads are created only as calendar spreads. You are long and short futures in the same market but in different months. An example of an intramarket spread is that you are long July Corn and simultaneously short December Corn. Other unofficial methods for creating intramarket spreads are beyond the scope of this course. Inter-Exchange Spreads Trading Spreads and Seasonals A less commonly known method of creating spreads is via the use of contracts in similar markets but on different exchanges. These spreads can be calendar spreads using different months, or they can be spreads in which the same month is used. Although the markets are similar, because the contracts occur on different exchanges they are able to be spread. An example of an inter-exchange calendar spread would be simultaneously long July Chicago Board of Trade (CBOT) Wheat, and short an equal amount of May Kansas City Board of Trade (KCBOT) Wheat. An example where the same month is used might be long December CBOT Wheat and Short December KCBOT Wheat. Offsetting Contracts Although both the long and the short futures may be entered simultaneously through a “spread broker,” it is often advantageous to enter a spread one “leg” at a time. However, until both the long and short futures are in place, there is no offset and consequently no spread exists. Offsetting merely defines the difference between the futures contracts, i.e., simultaneously both long and short futures. A spread consists of two “legs.” Each side of the trade constitutes one leg. Long futures is one leg and short futures is the other leg. There are times when offsetting may be accomplished by using inter- exchange spreads employing differing numbers of contracts. Let’s say, for instance, you are short 5,000 ounces of July Comex (CMX) Silver and would like to offset with an equal amount of June Silver. You could create the necessary inter-exchange calendar spread by purchasing five Mid- America Exchange (Mid-Am) June, 1,000 ounce Silver contracts. Currency positions at the Chicago Mercantile Exchange (CME) can be similarly offset by contracts at the Mid-Am. I can offset a long CME D-Mark contract with two Mid-Am D-Mark contracts. Sources of Spread Information All the major US exchanges publish materials on seasonal spreads. Generally this material can be had free or, at most, for a nominal charge. For example, the CBOT and the CME are happy to send you lovely color brochures showing charts of their exchange-recognized intermarket and intramarket spreads dating back over a period of 12 years. If you call and Trading Spreads and Seasonals ask, they will send them at little or no charge. Don’t forget to ask for both their commodity and financial futures material. Years ago, before the advent of computerized data bases, I used to obtain the CBOT’s “Year Book.” I am not aware if they still publish it, but it was chock full of tables giving actual prices for every contract for an entire year. It provided me with a complete data base of prices that at the time was incomparable. I used that data as a historical base for creating a history of which spreads worked best seasonally. It was laborious and tedious work, but I manually entered much of the data into my old Epson QX-10 computer so I could produce an historical graph. The public library where I lived carried the Year Book on its reference shelf and I made an arrangement with the head librarian to pick up last year’s volume as soon as they received the latest, newest volume. Seasonal tendencies in futures change little, if any, over the years. I still trade the same seasonal spreads today as I did decades ago. There are more seasonal spreads today than there were then because there are more markets in which to trade, and because computers are able to spot very short term trends in spreads that would have been difficult and impractical, if not impossible, to detect by manual methods. Today, you can trade not only agricultural spreads, but also exchange-recognized spreads in the currency, financial, energy, and metals futures. There is also an abundance of non-seasonal, intermarket and intramarket exchange-recognized spreads. Many of these non-seasonal spreads do have some seasonal tendencies and can be traded as seasonal spreads as well as outright spreads based on an event, fundamental knowledge, or some observable chart pattern. In addition to the material provided by the exchanges, there are also private sources of information on spreads. Some of these sources, with a brief description of each, are listed in the Appendix B of this course. Markets Suitable for Spreads When trading spreads, I am careful to trade in liquid markets and generally reject spreads in very thin markets. However, because there is essentially no such thing as “stop running” when trading spreads, I can afford to take them in markets that are a bit more illiquid than what I normally would consider Trading Spreads and Seasonals appropriate for trading. I consider the following markets suitable for trading spreads: Currency: British Pound, D-Mark, Swiss Franc, Japanese Yen. Any of these, one versus the other, on an intermarket basis. Energy: Crude Oil, Heating Oil, Unleaded Gas, Natural Gas. Any of these on an intermarket or intramarket basis, along with the “Crack Spread.” Grain: Corn, Chicago Wheat, Soybeans, Chicago Oats on an intermarket or intramarket basis. Chicago Wheat and Kansas City Wheat on an intermarket or intramarket basis. Soy Oil and Soy Meal on an intermarket or intramarket basis, and the Soybean “Crush” spread. Financial: US Treasury Bonds, Treasury Ten Year Notes, Treasury Five Year Notes, and Municipal Bonds on an intramarket basis and on an intermarket basis. (MOB spread, NOB spread, etc.) Two year notes on an intramarket basis. Eurodollars on an intramarket basis. T-Bills and Eurodollars on an intermarket basis. (TED Spread) Meat: Live Cattle and Live Hogs on an intramarket basis. Feeder Cattle on an intermarket basis with Live Cattle entered only as a spread. Metal: Trading Spreads and Seasonals Gold, Silver, Copper on an intramarket basis, and Gold, Silver on an intermarket basis. Softs: Cocoa, Coffee, Cotton, Orange Juice on an intramarket basis. (Caution: Coffee, Cotton, and Orange Juice in particular are among the world’s most treacherous markets and I never trade outright futures positions in any of them. In this writer’s opinion, trades in Cotton and Orange Juice should be avoided by non-commercial interests.) Of the above named markets, I will not take any trade that involves legging into a spread in any of the following markets: Orange Juice, Heating Oil, Unleaded Gas, Copper, Coffee, Cotton, Live Hogs, T-Bills, and Feeder Cattle. I will leg out of any of these only in dire emergencies, preferring to liquidate the trade intact, as a spread, both legs at the same time at a specified spread differential.
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